Question

3. Discuss the theory of Ricardian Equivalence. In your discussion, (i) state what the theory implies, (ii) discuss the assumptions needed for the theory to hold, and (iii) discuss the implications the theory has for using fiscal policy to stabilize the economy.

Answer 1

Ricardian Equivalence: It is an economic theory that argues that attempts to stimulate an economy by increasing debt -financed government spending are doomed to failure because demand remains unchanged. The theory argues that the consumers will save any money that they receive in order to pay for the future tax increases they expect to be levied in order to pay off the debt.

(i)The Ricardian argues that an individual or family rate of consumption is determined by the lifetime present value of their after tax income. The recipients of a government windfall perceive it as such. It's a bonus,not a long term increase in income.They will resist spending it because they know it's unlikely to recur and will even be clawed back in the form of higher taxes in the future.

Therefore,the government cannot stimulate consumer spending.

(ii)

• Agents are rational and farsighted
• Agents live forever or care about their progeny as much as they care about themselves.
• The belief that current budget deficits imply future taxes is correct.
• Taxes are lump sum.
• The availability of the deficit spending does not alter the political process.
• No distributional effects. Households are homogeneous , so that a representative agent model can be used.
• No liquidity constraints.
• Capital markets are perfect.

(iii)Sometimes the obvious is hard to perceive. Ricardian equivalence may be missing the obvious:forward looking, rational households should expect fiscal policy to work and their future incomes to be higher. A Ricardian perspective is therefore supportive of counter cyclical fiscal policy. Ricardian equivalence is typically cited as a reason why the effects of fiscal stimulus are undermined by forward looking households. HeI(Robert Barro) subsequently argues that the Ricardian approach suggests that households take the government's budget constraint into account when reacting to fiscal policy. Frequently then he assumes what he has to prove:that equivalence refers to the idea that forward-looking, rational households will perfectly offset the effects of changing government deficits or surpluses with commensurate changes in their own savings, but with the opposite sign.